What assumptions are required to assess the potential total return of a RMBS?

Question

What will be an ideal response?

Answer 1

The measure that should be used to assess the performance of a security or a portfolio over some investment horizon is the total return. The total dollars received from investing in a RMBS consist of (i) the projected cash flow from the projected interest payments and the projected principal repayment (scheduled plus prepayments), (ii) the interest earned on reinvestment of the projected interest payments and the projected principal prepayments, and (iii) the projected price of the RMBS at the end of the investment horizon.

To obtain the cash flow, a prepayment rate over the investment horizon must be assumed. The second step requires assumption of a reinvestment rate. Finally, cash flow yield or Monte Carlo simulation methodologies can be used to calculate the price at the end of the investment horizon under a particular set of assumptions. Either approach requires assumption of the prepayment rate and the Treasury rates (i.e., the yield curve) at the end of the investment horizon. The cash flow yield methodology uses an assumed spread to a comparable Treasury to determine the required cash flow yield, which is then used to compute the projected price. The Monte Carlo simulation methodology requires an assumed OAS at the investment horizon. From this assumption, the OAS methodology can produce the horizon price.